Small business owners to pay higher dividend taxes

From April 2016 the dividend tax rate will be increased to 7.5 per cent for basic-rate taxpayers, 32.5 per cent for higher-rate taxpayers and 38.1 per cent for additional-rate taxpayers.

The measure, included in the summer Budget statement, will change the economics of operating a small business as a limited company.

Current rates of tax on dividends are 25 per cent for higher-rate taxpayers and 30.56 per cent for those on the highest (45 per cent) rate, while basic-rate taxpayers pay no tax on their dividends. As a result many owners of small limited companies choose to be paid through a combination of minimum wages and the rest in dividends, minimising both income tax and national insurance contributions.

According to Craig Simpson of Baker Tilly, profits of a small family business taken as dividends are taxed at an effective rate of 20 per cent, as opposed to over 40 per cent if taken as salary. The difference is less for higher-rate taxpayers, but typically the saving is around 9 per cent when paying a dividend compared to salary.

The changes will leave most director-shareholders worse off, paying an extra 7.5 per cent in income tax, said Simpson. 'Whilst it may be an attempt to correct an imbalance it is still a real and unwelcome tax increase', he said.

Chris Jones, president of the Chartered Institute of Taxation, noted that the Budget changes mean that the dividend/wages strategy 'may no longer be the most efficient way of extracting money' from a company.

Moreover, from April 2016, companies where the director is the sole employee will no longer be able to claim the NIC employment allowance, making 'personal service companies' an even less attractive one-person business model. Some, especially those who pay the top 45 per cent rate of income tax, are likely to consider disposing of their businesses before the rules are implemented, commented Dermot Callinan TEP of accountants KPMG.

'This will make trading through the medium of a company less attractive, though not terminally so', commented tax advisors BKL. 'Company owners may wish to consider taking accelerated dividends before the change comes in April 2016.'

At the same time the existing 'dividend tax credit' is to be replaced with a tax-free dividend allowance of GBP5,000 a year for all taxpayers.
The new dividend tax model at least has the merit of being simpler, said Rachel de Souza of RBC Wealth Management: 'Eighty-five per cent of taxpayers should not be worse off as a result and the system of taxing dividends will be much more transparent.'

It is expected to raise an extra GBP6.8 billion for the Exchequer, mostly from top-rate taxpayers' contributions. Investors with modest portfolios will not pay any extra tax.

Chancellor George Osborne said the change was intended to deter small businesses from incorporating for tax reasons. This, he said, was a prerequisite for a planned further reduction in corporation tax to 19 per cent in 2017 and to 18 per cent in 2020.

Sources

• HM Treasury (full Budget statement, PDF file)
• Chartered Institute of Taxation
• Daily Telegraph
• Accountancy Age
• Pinsent Masons